Nick Schulz, who I’ve had the pleasure to have a few email exchanges with, steps into the anti-Consumer Protection arena with Protecting Consumers Against Another Failure of Government. He tries to find ways that the government can step out of the financial protection business to help even things up for them. I think he’s wrong here, but it is a good faith try. Two things of note:

For starters, Congress should support counter-cyclical loan-to-value ratios — that is, more stringent loan requirements during boom times and relaxed requirements in down times. This will be difficult for Congress because it means making the purchase of a home more difficult at times…

Last, the government needs to bury forever the government-sponsored enterprises that helped fuel the boom…To best help consumers, Congress should learn from this mistake by de-politicizing the housing market, starting with Fannie and Freddie.

So having Congress try and go counter-cyclical with minimum housing requirements would politicalize the mortgage process beyond anything Fannie and Freddie have done. Indeed I’m not sure how Congress would do this. Beyond all the hype about the government loosening standards, the only weapon in the arsenal without getting new powers is the definition of the conforming loan that Fannie/Freddie uses, and trying to get Congress to spin that counter-cyclically strikes me as asking for a disaster.

If he’s just concerned about LTV, the interest rate takes care of that by itself. In boom (bust) times, as the interest rate goes up (down), the NPV of a loan goes down (up); this encourages borrowers to either decrease (increase) the principal by paying more down payment or taking a smaller loan out (the opposite of that), making the LTV go down (up). The market is already on the case.

Should the terms of a vanilla loan adjust with the business cycle? No. The vanilla loan should serve as a floor of consumer protection, not as a means of trying to adjust the terms of credit lending during a credit cycle.

The three major ratings agencies amount to a government-sponsored cartel. And therein lies the problem: Large institutional investors who are forced by law to rely on the agencies are harmed when there is no competition…But these ratings agencies were the only game in town – large institutional investors could not rely on securities analysis from competitor agencies to make their decisions.

This is a good point, and I’m not sure what should be done about it. Alternatives I’ve heard, from backing out implied ratings information from cds and bond spreads to letting a thousand ratings agencies bloom all have their strengths and weaknesses. One thing that is worth noting is that nobody was unaware of the conflict of the ratings agencies, yet everyone was still taken by surprise. Everyone including international institutional investors, who aren’t subject to US government impositions. Perhaps it was a matter of the instruments in question being too complicated by the underlying mortgages in them.

Now note if we have a vanilla mortgage option, with a few alternative mortgage packages, CDOs could be structured in a way that used these mortgage options as building blocks. “This CDO is 95% vanilla”, is different than “This CDO is 95% prime” – and people would trade accordingly. That vanilla rating would be stamped by lenders under penalty of law. For all the talk about “subprime” it was obviously difficult to tell the actual performance of the mortgages in question, indeed what was even a subprime loan.

This is what Elizabeth Warren was getting at when she said: “While anyone with a bathtub and some chemicals could be a drug manufacturer a century ago, Carpenter points out that drug companies were willing to invest far more in research and development to bring good drugs to the market once FDA regulations drove out bad drugs and useless drugs. Good regulations support product innovation.” There’s an obvious informational asymmetry in underlying products; if we are going to continue to try and structure consumer debt to keep a capital markets banking system alive, having the government work to hurdle this asymmetry strikes me as very important. And providing floors on the quality of loans, with clear signals to buyers of packaged mortgages, may be worthwhile for both consumers of loans and the people who will ultimately end up holding them.

There’s a lot of talk about protecting consumers, but a Consumer Financial Protection Agency also ends up protecting those who end up on the ultimate other end of packaged consumer debt, be it pension funds in Denmark, a school board in Wisconsin, etc. Lord knows those people need protection too, and they may be against any type of innovation if these informational problems aren’t addressed.

9 Responses to Schulz’s Protecting Consumers From Consumer Protection

Personally, I think the first step toward real reform is to criminalize the issuance of a mortgage to someone with no hope of ever paying even the first monthly payment.

I remain astonished that this happened at such a broad level throughout the financial community. Great profit was made from making bad loans, followed later by a crash that brought down the global economy.

And all those toxic assets? They remain on the books, to be dealt with later….

“While anyone with a bathtub and some chemicals could be a drug manufacturer a century ago, Carpenter points out that drug companies were willing to invest far more in research and development to bring good drugs to the market once FDA regulations drove out bad drugs and useless drugs. Good regulations support product innovation.” — Elizabeth Warren

Harvard Professor Warren makes a very important point here which is often overlooked and underestimated.

I can tell you as a successful businessman, entrepreneur, salesman, and graduate of a top MBA school, the University of Michigan, that without sufficient government regulation (which is in many cases not that possible, but is often still highly possible) a business or salesperson can be at a substantial, or huge, disadvantage against competitors who are willing to do deceptively harmful or poor value things to customers. Often these things are very profitable because the customer cannot find out he was harmed, or received a poor value, until long after the sale, if ever.

Such unethical competitors, without government regulation or supervision, can drive out of the business the ethical ones, leaving only or predominantly unethical, or ethically willing to compromise, competitors. They may be the only ones who can survive against competitors who have the advantage of these unethical means, which, again, can in many cases, even if not always, be a big advantage in luring customers and increasing profits.

CEOs who don’t use these measures and thus have much lower profits will have a hard time keeping their jobs and reputations (for making money). And don’t try giving me long run arguments; often these unethical or deceptive or poor value methods maximize profit over the long run too. Moreover, how often do you see CEOs evaluated only over decades. Usually a few bad years, especially much worse than their competitors, even if those competitors are much less ethical, puts them in substantial danger of losing their super high paying jobs and never getting other ones nearly as high paying or prestigious.

There are just big asymmetric information problems; it’s very risky for boards and shareholders to believe the CEO when he says this is just a short run cost, wait 10 or 20 years and you’ll see it was for the best. First off it might not be with the time value of money, and second off if he’s lying or wrong you could lose enormous sums over 10 or 20 years. It’s very risky.

In any case, it just rarely happens. CEOs are at serious risk of losing their jobs after a few years of performance much worse than their competitors.

So lack of regulation (or other strong government role) in markets with a great deal of asymmetric information is clearly horrible for consumers, efficiency, and total societal utility. Much of the innovation and choice is in clever ways to better and more deceptively rip-off customers.

Good points. It’s worth noting that as our economy has become more sophisticated and jobs more specialized the problem of asymmetrical information has become potential much worse. People are required by today’s economy to spend years obtaining knowledge of a particular sector or a specific set of skills in order to successful. Unfortunately, most of the sectors they encounter as consumers are equally sophisticated and their studies may have had an opportunity cost in general knowledge as well.

How does moving from “prime” to “vanilla” help securitization matters? “Prime” tells you something about the loan (conforms to GSE rules) and the borrower (FICO>640). “Vanilla”, at least insofar as Warren seems to be using it, tells you something detailed about the loan (80/20 fixed-payment 30 year mortgage with no prepayment penalty, prepared according to a government document) and nothing about the borrower.

The adverse selection problem from this crisis would persist: loan originators still have incentives to approve as many people as possible to create as much product as possible. If you tell me your CDO is 95% vanilla, I don’t know if I just bought a bunch of Pebble Beach mortgages held by people with substantial assets outside of the houses in question or a bunch of Flint mortgages that just happen to have conventional terms.

Taunter, they’re not making them “vanilla” so the banker can understand it better. They’re making it vanilla so the person getting the mortgage can see on the face of it what he’s getting into. The idea is to make a better informed consumer, so they know what they’re getting into. The lenders obviously usually know the poor bastard will never be able to pay it off.

The vanilla ratings stamp is a great idea. It’s such a great idea, I can almost guarantee it will never happen. But it’s nice to see Mike show there are many ways to solve these problems, just a refusal by bankers and corrupt Congressmen to enact them.

I don’t know if this falls under your or Shulz’s definition of counter-cyclical LTV’s. But I think a flaw in the underwriting process is the reliance on comparable sales as more or less the sole determiner of value for residential loans. In a wide spread bubble that doesn’t provide a great deal of security (ie Phoenix). Augmenting the traditional appraisal with standards on gross rent multipliers, with PMI kicking in if the GRM goes above the range would be a great addition to Vanilla lending. It would also be a decent signal to investors and home buyers that a bubble is forming.